Oil Majors to Thrive as Market Enters a Period of ‘Restraint’

The largest oil companies usually thrive during periods following downturns, when the oil market rebounds but has not entered a new boom phase.

Even though oil prices are sharply down from pre-2014 levels, the largest oil companies are entering a “Golden Age” in which they will see wider profit margins. One would assume that the oil majors would typically perform best when oil prices are high, “but historical evidence shows that producers actually fare poorly” during these boom times, Goldman Sachs wrote in a new report.

Instead, the largest oil companies usually thrive during periods following downturns, when the oil market rebounds but has not entered a new boom phase. This environment is ideal for the majors: Lower production costs, consolidation, and cautious spending allow them to post massive returns.

Oil market in a period of “restraint”

Soaring shale production and the prospect of muted price gains, perhaps for years to come, does not seem like a promising period for the oil majors. But Goldman Sachs laid out its case in a new report that the large multi-national companies are currently well positioned. The oil and gas sector typically goes through 30-year investment cycles that are characterized by three distinct phases, which the investment banks dubs Expansion, Contraction, and Restraint.

On the surface, the majors would appear to benefit the most from the boom, or Expansion, phase. After all, higher oil prices should translate into higher profits. But Goldman notes that cost inflation and overspending typically undermine returns during these upcycles. From 2003-2013, a period of rising oil prices with the exception of late 2008 and early 2009, the oil majors “underperformed the market by 1 percent on average, driven by weak free cash flow and multiple de-rating,” Goldman analysts wrote.

Ultimately, a wave of new supply comes online after the increased investment and drilling reaches completion, leading to a crash in oil prices and a period of “Contraction.”

The “Contraction” period of 2014-2017 is now very familiar to most market watchers. Oil prices plunged sharply during the second half of 2014 and bottomed out in early 2016. The oil industry suffered from a sharp decline in revenues, resulting in layoffs, a slowdown in drilling, project cancellations, and bankruptcies. The oil majors survived, but were forced into severe spending reductions as debt mounted.

Goldman says that the “Restraint” phase has historically been a period of time in which the majors have performed the best. The market has mostly healed from the “Contraction” phase, clearing away excess inventories. Demand growth has absorbed the supply surplus. But there are still lingering concerns about long-term oil prices, which means that in the aggregate, the oil industry is holding back on investment, keeping spending in check.

Uncertainty about long-term oil prices creates barriers to entry, solidifying the position of the majors.

Moreover, uncertainty about long-term oil prices creates barriers to entry, solidifying the position of the majors. “[L]ong-cycle investment consolidates in the hands of a few large companies that can self-ﬁnance the new investments,” Goldman says, while cost deflation leftover from the bust helps keep costs down. An example of this might include BP’s decision to greenlight its Mad Dog Phase 2 in late 2016, a large offshore drilling project in the Gulf of Mexico. The market downturn allowed BP to slash its cost estimate for the project by more than half to $9 billion.

Meanwhile, the largest oil companies, unlike their smaller counterparts, were able to purchase discounted assets during the bust, allowing them to benefit from a wave of consolidation. While some E&Ps may have suffered irreparable damaged during the “Contraction” period, the majors emerged on the other side with new opportunities that they took over from struggling companies.

Goldman pointed to the 1987-2002 “Restraint” phase that saw high returns for the majors, even as returns for ordinary E&Ps “lagged.” The “Seven Sisters” outperformed the global market by a 6 percent annual average in terms of total shareholder returns over that time period.

“Golden Age” for the majors

The historical context is important because Goldman says that 2018 marks the beginning of a new “Restraint” phase. The oil market has recovered from the collapse that began in 2014. Yet, there are very few signs yet of an extremely tight market that would usher in a new period of “Expansion.” The majors have sold some assets but purchased others to strengthen their positions. There are long-term concerns for the oil industry over the threat of alternative fuels in the transportation sector and peak demand, holding back investment. That dynamic leaves potential growth mostly in the hands of the oil majors.

The one caveat—albeit a long one—to Goldman’s argument is shale, which is a brand new factor when looking at decades of investment cycle history in the oil market.

“The Restraint phase, instead, sees a slow, consistent improvement in returns, led by an oligopolistic market structure, better management of the supply chain and advantaged resource access,” Goldman Sachs wrote in a note. “This is reﬂected in Total Shareholder Returns, which are driven by [cash return on cash invested], not the oil price.” Returns grow steadily in the Restraint phase, with credit ratings repeatedly upgraded.

The one caveat—albeit a large one—to this story is shale, which is a brand new factor when looking at decades of investment cycle history in the oil market. That means that E&Ps, not just the oil majors, can also grow in this period of Restraint. Nevertheless, the shale sector may not significantly alter the outlook for the oil majors. In a show of confidence about its argument, Goldman issued “Buy” ratings for Total, Shell, Eni, Chevron, and ConocoPhillips.

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The Fuse is an energy news and analysis site supported by Securing America’s Future Energy. The views expressed here are those of individual contributors and do not necessarily represent the views of the organization.

Issues in Focus

Safety Standards for Crude-By-Rail Shipments

A series of accidents in North America in recent years have raised concerns regarding rail shipments of crude oil. Fatal accidents in Lynchburg, Virginia, Lac-Megantic, Quebec, Fayette County, West Virginia, and (most recently) Culbertson, Montana have prompted public outcry and regulatory scrutiny.

2014 saw an all-time record of 144 oil train incidents in the U.S.—up from just one in 2009—causing a total of more than $7 million in damage.

The spate of crude-by-rail accidents has emerged from the confluence of three factors. First is the massive increase in oil movements by rail, which has increased more than three-fold since 2010. Second is the inadequate safety features of DOT-111 cars, particularly those constructed prior to 2011, which account for roughly 70 percent of tank cars on U.S. railroads. Third is the high volatility of oil produced from the Bakken and other shale formations, which makes this crude more prone towards combustion.

Of these three, rail car safety standards is the factor over which regulators can exert the most control. After months of regulatory review, on May 1, 2015, the White House and the Department of Transportation unveiled the new safety standards. The announcement also coincided with new tank car standards in Canada—a critical move, since many crude by rail shipments cross the U.S.-Canadian border. In the words DOT, the new rule:

Since the rule was announced, Republicans in Congress sought to roll back the provision calling for an advanced breaking system, following concerns from the rail industry that such an upgrade would be unnecessary and could cost billions of dollars. The advanced braking systems are required to be in place by 2021.

Democrats in Congress have argued that the new rules are insufficient to mitigate the danger. Senator Maria Cantwell (D-WA) and Senator Tammy Baldwin (D-WI) both issued statements arguing that the rules were insufficient and the timelines for safety improvements were too long.

The current industry standard car, the CPC-1232, came into usage in October 2011. These cars have half inch thick shells (marginally thicker than the DOT-111 7/16 inch shells) and advanced valves that are more resilient in the event of an accident. However, these newer cars were involved in the derailments and explosions in Virginia and West Virginia within the past year, raising questions about the validity of replacing only the DOT-111s manufactured before 2011.

Before the rule was finalized, early reports indicated that the rule submitted to the White House by the Department of Transportation has proposed a two-stage phase-out of the current fleet of railcars, focusing first on the pre-2011 cars, then the current standard CPC-1232 cars. In the final rule, DOT mandated a more aggressive timeline for retrofitting the CPC-1232 cars, imposing a deadline of April 1, 2020 for non-jacketed cars.

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DataSpotlight

The recent oil production boom in the United States, while astounding, has created a misleading narrative that the United States is no longer dependent on oil imports. Reports of surging domestic production, calls for relaxation of the crude oil export ban, labels of “Saudi America,” and the recent collapse in oil prices have created a perception that the United States has more oil than it knows what to do with.

This view is misguided. While some forecasts project that the United States could become a self-sufficient oil producer within the next decade, this remains a distant prospect. According to the April 2015 Short Term Energy Outlook, total U.S. crude oil production averaged an estimated 9.3 million barrels per day in March, while total oil demand in the country is over 19 million barrels per day.

This graphic helps illustrate the regional variations in crude oil supply and demand. North America, Europe, and Asia all run significant production deficits, with the Middle East, Africa, Latin America, and Former Soviet Union are global engines of crude oil supply.